The Classical Model

1
The Classical Model

• Lets assume that country A is endowed with 12,000
  hours.
• What would be the maximum amount of S and T that
  could be produced?
• County B is endowed with 9,600 hours.
• What would be the maximum amount of S and T that
  could be produced?

2
PPF of Country A and B
T
T
1200
2000
Slope3/2
Slope1/2
S
4,000
800
S
Country A
3
The Classical Model

• Why is the PPF a straight line?
• Because of assumption of fixed input-output
  technology.

4
The Classical Model

• By plotting the PPF, we can establish autarky
  price in both the countries.
• From chapter 2, we know that slope of the PPF is
  equal to the countrys relative prices (Ps/PT).

5
Pretrade Equilibrium in Country A and B
T
T
1200
L
2000
Slope3/2
Slope1/2
K
S
4,000
800
S
Country A Price of S is 1/2 unit of T
Country B Price of S is 3/2 units of T
6
The Classical Model

• What would happen to pre-trade solution for each
  country if the two were allowed to trade?
• Pre-trade situation
• Autarky price of S is lower in A than in B.
• Autarky price of T is lower in B than in A.
• Can these price differential still exist after we
  allow trade?

7
The Classical Model

• After trade situation
• The demand for S will rise in A and fall in B.
• Thus, relative price for S will rise in A and
  fall in B.
• Similarly, demand for T will rise in B and fall
  in A.
• Relative price for T will rise in B and fall in
  A.
• Thus, PS/PT will continue to move until a new
  equilibrium

8
The Classical Model

• Thus, PS/PT will continue to move until a new
  equilibrium is reached.
• Once the equilibrium is reached, there will be
  only price, knows as world price.
• The world price will be somewhere between ½ (As
  autarky price) and 3/2(Bs autarky price). This
  price is known as terms of trade.
• Lets assume terms of trade to be 3/4. What would
  happen in each country?

9
Terms of Trade

• In country A
• producers of S received ½ unit of T for their
  output
• producers of T received 2 units of S
• Now producers can sell their output to consumers
  from both countries for an equivalent of ¾ units
  of T
• In country B
• producers of S received 3/2 units of T for their
  output
• Producers of T received 2/3 unit of S

10
Terms of Trade

• Free international trade leads each country to
  specialize in the production of its
  comparative-advantage good
• Production of the good with lower autarky price
  expands
• Country with low autarky price of a good has a
  comparative advantage in that good
• Production and trade follow the line of
  comparative advantage

11
Graphic presentation of specialization process
T
T
R
1200
N TOT(slope)3/4
D
M TOT(slope)3/4
2000
L
K
P
O
O
S
H
4,000
800
S
Country A
Country B
12
Walras Law

• These two trade triangles are congruent
• Walras law in a world with n markets, if any n-1
  markets are in equilibrium, so too will be the
  nth market
• The economic process that makes both the
  triangles equal is known as reciprocal demand.

13
Reciprocal Demand

• Reciprocal demand refers to interaction of supply
  and demand.
• If the demand is not equal to supply in the world
  market, the international price will change to
  bring about equality.
• The price of imports of the country with larger
  trade triangle must rise so that the residents
  will demand less.
• Similarly, price of the imports of the country
  with the smaller trade triangle must fall so that
  its citizen will want to trade more.

14
Summary

• It is not necessary for a country to have
  absolute advantage in the production of some
  commodity to be able to participate in
  international trade.
• International trade will occur along the lines of
  comparative advantage.
• After trade, there will be one price and will lie
  somewhere between the autarky prices of the two
  countries.

15
Gains from International Trade

• Who benefits from Trade?
• Do both countries gain from trade?

16
The gains from trade in country A
T
Slope PS0/ PT0
GDP1/PT0
M
CIC1
GDP0/PT0
K
CIC0
S
H
O
P
17
Sources of the gains from trade

• Two sources for gains.
• There are consumption gains from trade.
• Country A can purchase good more cheaply.
• There are production gain from trade.
• International trade causes production to be
  centered in those sectors where As labor is
  relatively more efficient.

18
Gains from trade

• How substantial are these gains?
• It differs from country to country and depends on
  how much the terms of trade differs from the
  pretrade price ratio.
• Example of Japan

19
Japans Gains from Trade

• Japan was an autarky until 1858
• Specialized in two major exports silk and tea
• In autarky their prices were very low
• With trade prices went up for silk by 26 in
  real terms, for tea more than 50
• Prices of imports fell by 39 in real terms
• Within 12 years foreign trade had increased by
  7000

20
The Relationship between Trade and Wages

• Both industries are perfectly competitive and
  labor is the only factor of production receives
  payment
• In pretrade following relationships holds
• PSA WA X hoursSA WA X 3
• PTA WA X hoursTA WA X 6
• PSB WB X hoursSB WB X 12
• PTB WB X hoursTB WB X 8

21
The Relationship between Trade and Wages

• For trade to occur along the lines of comparative
  advantage following must hold
• PSA lt E x PSB and PTA gt E x PTB
• E is the exchange rate, E 2
• 4/3 lt WA / (E x WB) lt 4
• relative wage ratio
• As workers produce more output than Bs workers
  and should earn higher wages for their work
• As wage rates rise, prices will too

22
An Evaluation of the Classical Model of Trade

• This model is in existence for over 200 years
• Trade occurs along the lines of comparative
  advantage
• International trade leads to a higher standard of
  living for the countries involved
• Problems with this model
• This model is incomplete (does not explain why
  differences in productivity levels exist between
  countries)
• Prediction that country will completely
  specialize in the production of exportable goods
• Greatest gains from trade between countries with
  dissimilar technologies